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January, 2011 (Chinavestor) What a difference a year makes! China stock investors were bullish at the beginning of 2010, hoping the 80% gain for the Shanghai Composite Index (SHA:000001) in 2009 was to slow down a bit—yet reality proved to be different. Not only did the mainland’s most liquid index slow down but actually fell hard in the first six months of the year, a complete opposite of what investors had hoped for. Despite some gains, the Shanghai Composite Index (SHA:000001) ended 2010 deep in the red, with a 14.3% decline for the 12 months. This makes it one of the worst performers of major markets around the world.

Key stocks mentioned in this Newsletter include China Life Insurance (NYSE:LFC), HSBC Plc. (NYSE:HBC), E-House Holdings (NYSE:EJ), and Xinyuan Real Estate (NYSE:XIN) in the first part of the report. The second, stock specific part highlights China Housing & Land Development, Inc. sphere and Baidu.com Inc. (NASDAQ:BIDU) Sina Corp. (NASDAQ:SINA), Sohu.com Inc. (NASDAQ:SOHU), NetEase.com (NASDAQ:NTES), SouFun Holdings (NASDAQ:SFUN), and Shanda Games (NASDAQ:GAME) from internet and related sectors. China Mobile (NYSE:CHL) and China Telecom (NYSE:CHA) are stocks from the telecom sector in the Newsletter. (NASDAQ:CHLN) from the real estate

Investors in Hong Kong were more fortunate for the year, thanks to a resurgent U.S. equity market. The Dow Jones Industrial Average (INDEXDJX:.DJI) surged for the year, adding 11.02% on top of 2009 gains.

Interest rates in the quasi city states are tied to the dollar, making real estate and financials stocks, a large chunk of the Hang Seng Index (INDEXHANGSENG:.HSI) , correlating closely with their western counterparts. As a result, the main gauge of Hong Kong, ended the year up 5.3%, a significant improvement from the Shanghai Composite Index (SHA:000001).

Western investors interested in Chinese stocks had a less successful year in 2010 than those in Hong Kong. The China ADR Index (red on the chart), compiled by Chinavestor, ended the year 6.5% in the red, a significant disappointment over 2009. Most of the drop is attributed to index heavy weight China Life Insurance Co. (NYSE:LFC) and HCBC Plc. (NYSE:HBC), whose ADRs fell 16.6% and 10.6% in 2010, respectively. And while most small cap stocks cheered western investors for the year, the utter delisting of highly liquid Rino (PINK:RINO) and Tongxin Int. (PINK:TXIC) from the NASDAQ were another new development in the history of Chinese ADR listing. Another significant setback for Chinese ADRs was on September 10, when NYSE listed Duoyuan Global Water (NYSE:DGW) and Duoyuan Printing (NYSE:DYP) fell apart following rumors of financial wrongdoings. The emergence of “auditing the auditor” is a new phenomena of the year, something that western investors have to do as part of due diligence from now on.

The rule of thumb with auditors is that companies with market cap of over $250 million could typically afford a top four auditor. But the issue of investors trust became paramount in 2010, making smaller stocks switching to expensive top four auditors. Investors have embraced stocks that upgraded auditors, like $150 million small cap General Steel (NYSE:GSI), that jumped 9.8% on December 29 following a switch to PWC.

Looking forward to 2011, we are optimistic at Chinavestor for the following reasons.

Looking at the history of Chinese stocks for the past three years, 2008 was a disaster. This is when the financials meltdown hit equities world wide. But Chinese stocks made an incredible comeback in 2009, sending the Shanghai Composite Index 80.0% up for the year. 2010 saw a correction or consolidation as investors realized that the recovery for the global economy will be slower and more gradual than originally thought. This helped push P/E for Chinese stocks back to 17, half of that at the end of 2009. So Chinese stocks look good on valuation at the beginning of 2011.

Another positive development is the recovery in the world’s largest economy, the U.S. The core of the problems in 2008 was mortgage crisis, something that has been turning around without much acclamation. The number of defaults fell while home sales have been inching up as 2010 came to an end. Meanwhile, first time jobless claims dropped to the lowest by the end of the year since July of 2008, another positive development for the sustainability of the recovery. A record strong Holiday shopping not only boosted retail stocks but gave another indication about rising consumer confidence in the U.S. Considering that consumption makes up three quarters of GDP growth here at home, consumer spending is a vital indication about the health of our economy. Improving home sales and jobless numbers combined with improving consumer confidence is an excellent mix to get 2011 stated.

Another boost for the DJIA is coming from potential problems with the Euro. Investors watch Spain, Portugal and Italy very closely at the moment, pressuring the Euro and boosting the dollar in return. A strong dollar helps keep inflation at bay at home, giving the FED a cushion needed to stimulate the economy. A presumed economic growth will trickled down to sound earnings growth, buoying the DJIA in return.

While the dollar may continue to hold firm against the Euro, it surely will continue to fall against the Yuan in 2011. Reason being is the rising inflation in China which is going to be kept at bay by more interest rate hikes. A modest interest rate hike offers Chinese authorities a tool to fight inflation without sacrificing economic growth. It is anybody’s guess how long the Chinese will be able to keep the Yuan pegged to the dollar with a yawning gap between the interest rates of the green back and the Yuan. A stronger Yuan bodes well for domestic oriented stocks like telecoms and airliners whose dollar value is lifted each time the Yuan gets stronger.

The Chinese financial sector is another place that offers investors upside potential going forward. We have been excessively publishing about the superb profitability of the Chinese banking sector as late as the third quarter of 2010. Despite high capitalization and record profits, financial stocks suffered both in Hong Kong and Shanghai due to multiple interest rate hikes in 2010. But most of the bad news is already incorporated into stock prices of Chinese financial institutions, making a case for the sector. While investors in the U.S. have limited access to Chinese banks, HSBC Plc. (NYSE:HBC) is one choice and financial heavy weight iShares FTSE/Xinhua 25 China Index (NYSE:FXI), is another.

Besides financials, the Chinese real estate sector is another developing story. There has been a lot of speculation and bad mouthing about a Chinese property bubble, yet there had been no signs of an actual bubble forming not to mention bursting. With the pressure off the sector, real estate and related stocks offer opportunity for the riskier investor.

One of the reasons for no burst of the alleged bubble is sustained sound demand for housings thanks to rising income in rural China. Increase in food prices may spur inflation but is actually encouraged by policy makers concerned about spreading wealth to farmers in the western parts of the country. Assuming this trend, e.g. spreading wealth to the rural west, is going to continue into 2011, fundamentals for the real estate sector look promising.

But investors have to be careful when it comes to individual stocks. NYSE listed E-House Holdings (NYSE:EJ) and Xinyuan Real Estate (NYSE:XIN) reported negative quarterly earnings growth for most of 2010, suggesting these ADRs lack fundamentals going forward. But China Housing & Land Development Inc. (NASDAQ:CHLN) returned to profitability improving outlook for fundamentals going forward.

Talking about individual stocks: we remain bullish about stocks that are industry leaders, have strong cash position and portray sound revenue and earnings growth.

Shanda Interactive (NASDAQ:SNDA) and Shanda Games (NASDAQ:GAME) look good on valuation and are fine companies, although latest earnings shook investors’ confidence. But risky investors may want to give Shandas a chance.

On the same token, China Mobile (NYSE:CHL) and China Telecom (NYSE:CHA) are our favorites from the sector, based on sales growth and technology.

The Chinese solar sector looks good on fundamentals albeit some argue that over production will hurt profitability going forward. We don’t see facts supporting this hypotheses at this point.

Small cap Chinese stocks will remain in the high risk / high return category.

Wish you successful investing

Blaze Fabry

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